Revenues, costs and profits

Price maker

A firm that has to cut its price in order to sell more

Price taker

A firm has to offer its price at the same price as everyone else

Demand is also known as

Average revenue (AR)

Parabola shape

Like a U

Shape of a total revenue curve

Parabola shaped

• This means, that as price falls, the revenue will rise, but it rises more slowly each time price is cut, up to the point of maximum revenue (MR), where revenue won’t increase anymore

Revenue maximisation

Where the firm makes as much money as it can

Marginal revenue

The increase in revenue when one more unit is sold

The reason MR is less than AR

Because when price is lowered, the firm loses money on all the items it is already selling

Average revenue

The price the firm receives per unit sold.

An average revenue curve is the same as the demand curve, or price

• For average revenue, a price taker has a horizontal demand curve, which is perfectly elastic.

• A price maker has a downward sloping demand curve and we draw marginal revenue on the same graph with a gradient twice as steep

Normal profit

The amount the risk taker must receive to keep resources at their current usage.

This is considered a cost

Total fixed costs (TC)

Costs that do not change with output

Total variable costs (TVC)

Costs that change with output

Average cost

AC is total cost divided by the amount produced, or quantity. These are also known as Average Total costs (ATC).

The cost per unit falls as production increases, because the fixed costs are spread over more units of output.

Average fixed cost

This is the cost of overheads such as rent.

Because fixed costs do not change with output, then fixed cost per unit must always fall.

Average variable cost

Average variable costs are the costs per unit of factors that change as more is produced.

Relationship between MC and AVC

When MC is below AVC, AVC falls because the cost of producing the next unit is less than the average, so it pulls the average down. (Vice versa)

If the marginal is the same as the average, the average stays the same.

The relationship of this is the same as that of MC and AC, only difference is that the AC cost curve will be higher because of the inclusion of fixed costs.

Marginal cost (MC)

The cost to the firm of making one more unit of output.

The law of diminishing returns

As more of a variable factor is added to a fixed factor, the increase in output (or marginal product) eventually falls.

Initially there will be an increase, but each worker will find it more difficult to achieve more output because there are so many people because maybe all the easy tasks have been done (only hard ones left), or the fixed factors have too many ppl on them (think ovens in a restaurant.)

So each workers Marginal product will decrease eventually, so total output increases but at a decreasing rate.

Increased the fixed factors (machinery etc, can help sovle this, this is only in the long run)

This is only for the short run

Marginal product

The extra output when one or more factor of output is added

Fixed factor

This is the factor of production, which can’t be changed in the short run

Economies of scale

Long run and costs

There are no fixed costs in the long run because all costs are variable, because there are no fixed costs, there can’t be the law of diminishing returns.

Economies of scale

This occurs when there is a decrease in the average costs per unit when output increases for the firm in the long run

Internal economies of scale

Advantages that arise within a firm, and under managerial control

Types of economies of scale

• Managerial

• Technical

• Purchasing

• Marketing

• Financial

• Risk-bearing

Managerial EoS

Specialist and skilled managers boost worker productivity because of the managers knowledge/skillset, total cost rises slower than output.

Technical EoS

Specialised (Designed for specific task) machinery of division of labour raises efficiency. Total costs increase, but output increases faster, so ACPU falls.

Purchasing EoS

Bulk buying secures unit discounts, which spreads the purchasing cost over more units

(e.g ordering raw materials in large shipments)

Marketing EoS

Bulk advertising (TV spots, billboards) reduces per unit ad cost, spreading marketing expense

Financial EoS

Larger firms can achieve lower interest, because they’re seen as less risky, so costs are lower

Risk bearing

Firms can spread risk across more output, e.g having a wide portfolio rather than just one unit line

Minimum efficient scale (MES)

The smallest level of output in the long run that a firm can produce while still taking advantage of internal economies of scale

Resulting in the lowest possible LRAC (long run average cost)

MES relative to the size of market demand

If the MES is very high compared to market demand, few firms can operate at the MES, because there just isn’t enough demand for more firms to produce more output at that level.

This results in Monopolies, duopolies, and oligopolies.

Low MES: a more competitive market is likely

What affects the MES

• High costs (for pharmaceuticals, R&D are at very high levels, and can take years. Coupled with a tightly regulated market, costs are very high, so the firm needs to produce at even higher quantities to bring down AC)

Diseconomies of scale

When firms become too big and their cost per unit increases as output increases

Reasons for diseconomies of scale

• Unwieldiness

• Slowness

• X-inefficiency

• Communication

• Lack of management

Unwieldness

When large firms become to difficult to manage

• Decisions take longer to implement

• People making the decision may not have sufficient knowledge as they are further away from workers (local conditions etc if it is multinational)

Slowness

It takes a large firm a long time to respond in many cases

• This is due to more layers of management, decisions and info need to pass through more people

X-inefficiency

• Lack of competition for a large firm may mean costs rise

Communication

Lots of e-mails, meetings mean workers face delays in completing tasks

Lack of engagement

The managers may become very distant from the worker, workers may then become less loyal to management and the purpose of the firm, so they take more days off sick, or spend time working inefficiently.

External economies of scale

When an industry as a whole grows and the firms within the industry benefit from it.

However diseconomies of scale may occur as a market may be flooded with too many firms for example.

Profit

The difference between revenue and costs

Marginal profit

The extra profit gained when one more unit of output is produced.

When profit maximisation occurs

When the cost of producing one extra unit of output is equal to the revenue gained from selling that unit

Efficiency

Efficiency measures how well resources are used, that is, the output relative to some other factor, such as the cost of resources used

Types of efficiencies

• Allocative

• Productive

• Dynamic

• X-inefficiency

Allocative efficiency

This occurs when resources are used to produce the goods and services most desired by society - it is where price=MC (AR=MC)

Productive efficiency

Where a firm operates on its lowest average cost, which is the lowest point on the average cost curve.

In terms of consumer surplus, this is the optimum output.

However, there is very little incentive for a firm to operate at productive efficiency, and no incentive to lower the price this much.

Dynamic efficiency

When a firm improves efficiency over time by investing in innovation, new technology and human capital.

Leads to lower LRAC (long run average costs)

X- inefficiency

Production occurs above the AC curve

When costs rise because there is no competition.

When costs rise there’s no incentive to cut back, because prices don’t matter due to no competition.

If wages and employment aren’t dependent on the revenues, workers may not try hard to increase sales volume.

X-efficiency

When a business minimises waste. i.e there are no excess costs.

Production occurs on the AC curve

Characteristics of perfect competition

• Many buyers and sellers in the market. Neither of them can influence price, we say they are price takers and firms face a horizontal demand curve AR = MR

• There are no barriers to entry or exit

• There is perfect knowledge or information e.g about production techniques and sources of cheap raw materials.

• All firms aim to maximise profits, MR=MC